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A Russian Crisis No More?

21 August 2020   |  

Russia has had its fair share of market-moving news this year. Normally, the dispute with Saudi Arabia over oil production and President Putin’s announcement he would reset his term limits would take center stage—yet both have been overshadowed by the dual threats of COVID-19 and the corresponding pressure on oil demand. The economy has predictably struggled, with GDP down 9.6% YOY in Q2, while personal incomes fell 8.0%. Predictably, the ruble has also weakened relative to both the euro and USD—likely a byproduct of not only relative economic weakness but also the oil price collapse.

While the market has responded as we might expect (the MSCI Russia Index is down 22.5% YTD through July in USD terms), Russia is nevertheless still near the middle of the EM pack. It trails countries which have rebounded sharply, such as China and Taiwan, while leading harder-hit compatriots Brazil, Turkey, Hungary and Greece.

Though such conditions in years past could have prompted investor concerns about a deeper Russian collapse (and, potentially, contagion beyond its own borders), the country’s recent steps to fortify itself have potentially positioned it for a rebound. And the first bit of evidence the rebound may be starting could be the Russian bond market: Russian government bonds have outperformed most EM bond markets as the country’s low debt-to-GDP ratio and increased flexibility to manage the ruble better arm it to handle heightened volatility. Even the ruble’s decline compared to major currencies lacks the dramatics it experienced during the 2008 global financial crisis or the Russian financial crisis of 2014.

It’s easy to get preoccupied with some of the Russian government’s global affairs, but they shouldn’t overshadow some sound policymaking over the past few years. Current fiscal rules help dampen the impact of oil price volatility on the ruble and Russian inflation by requiring a portion of oil revenues be placed in a National Welfare Fund—currently 10% of GDP—and the purchase of foreign currencies when oil prices are high, and conversely drawing upon those savings and selling foreign currency reserves when oil prices are low. Better control over inflation thanks to a floating currency whose movement is less influenced by oil’s price swings gives Russia’s central bank more flexibility to reduce interest rates when the local economy needs stimulus. In addition, the government has more ability to implement countercyclical policies, given public sector debt is around 15% of GDP—among the lowest in the emerging world—allowing ample room to borrow funds without fearing a ratings downgrade.

Nor is it all government-led initiatives. Russian firms have improved stewardship of shareholder capital in recent years, which has led to smarter capital investments, greater willingness to return capital to shareholders, more efficient operations and higher returns on capital. Increased ESG awareness is also evident within the mining and metals industry as companies adapt to demands from the European investor community. Positively, the stewardship efforts extend to state-owned enterprises (SOEs), too: A rule introduced in recent years requires SOEs to pay out at least half their profits in dividends—which has incentivized them to make better capital allocation decisions. Together, these trends have reduced debt costs, improved earnings and lowered equity costs—hence, higher PE multiples.

With many Russian corporate balance sheets still in good shape, all things considered, dividends remain fairly intact and comparatively high. The MSCI Russia Index’s dividend yield (in USD) was 6.4% at the end of July, compared to 6.9% at the end of 2019. Meanwhile, the MSCI EM Index’s dividend yield on the same dates were 2.4% and 2.6%, respectively.

Of course, risks remain. Additional sanctions by the US or international community, whether related to the Syrian conflict or another geopolitical event, are possible. When it comes to oil, Russia and OPEC+ could butt heads, raising concerns about another production war. Given Putin’s hold on power, policies can always reverse at his discretion. And there remains the more immediate risk COVID continues damaging the Russian and global economies.

But at a time of elevated uncertainty and scarce yield, Russia has bolstered its position with a layer of financial security that helps mitigate risk. Time will tell how that impacts domestic bond and equity market returns.

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